The US government’s plans to subsidise purchases of toxic assets may inadvertently make it even harder for struggling companies to refinance their debts.
The details still are being thrashed out for the public-private investment plan (PPIP) announced last week by Tim Geithner, Treasury secretary, as part of a plan to remove toxic loans and securities backed by those loans from banks’ balance sheets.
With leverage supplied by the government, the returns on some of these loans and securities could reach 20 per cent. Because the government is expected to take most of the losses if these investments turn sour, investors expect buying risky corporate debt directly to become less enticing. “If I am an investor and I can get 18 per cent on a triple A bond with non-recourse financing under a government programme, why would I buy high-yield?” said a senior trader at a large bank.
After its worst annual performance in 2008, the high-yield market showed signs of life in the first quarter. Returns on junk bonds were 5 per cent, according to a Merrill Lynch index. Dealogic says US companies with ratings below investment-grade raised $11.3bn. However, there has only been one high-yield deal in Europe since the credit crunch began and that was Fresenius in January.
Even in the US, investors are only willing to lend to selected companies. For the riskiest issuers, credit remains extremely expensive or impossible to obtain, which has forced many companies to resort to exchanging existing debt for equity or new bonds of lower value.
With the average junk bond yielding nearly 19 per cent, federal programmes aimed at lowering borrowing costs have failed to reduce rates for the companies that potentially need help most. To the extent that the PPIP works, which is still unclear, it should ultimately benefit all companies by freeing up banks to lend again.
In the short term, the outlook for corporate debt may worsen should the PPIP “crowd out” distressed assets other than the toxic debt eligible under the plan.
“The distress cycle may take longer to work itself out, and recoveries will be lower, if any capital that otherwise would have been provided as DIP [debtor-in-possession] financing bleeds over into PPIP-eligible assets,” analysts at Morgan Stanley wrote in a recent report.
Companies need DIPs to fund operations while they reorganise in bankruptcy. Without a DIP, liquidation often ensues, leading to greater credit losses.
Higher quality companies are not immune because they will have to compete with other triple-A rated assets that investors can buy with loans from the government. “Our theme of ‘sequenced’ healing of credit markets gets up-ended, as higher quality corporate credit gets swept aside in favour of other triple A assets [primarily commercial mortgage-backed securities] that can be purchased with non-recourse financing, and lower quality high-yield and syndicated loans likely lag [behind] for longer than we anticipated,” the analysts said.
Cheap junk bonds have drawn buyers this year on the belief that trading levels reflect an overly pessimistic default scenario. Some observers caution that, if, as expected, investors get less of their money back on defaulted debt than they have in previous downturns, the yields would not be so generous.
In the credit boom, companies and their bankers piled on various layers of claims, a tactic that leaves less to go around in a default.
“Do not believe the hype that spreads in corporate credit markets are pricing in Armageddon-like defaults,” said Tim Backshall, chief strategist at Credit Derivatives Research. “If we adjust for realistically low recoveries …then default rates actually become more in line with historical cycles and the compensation that talking heads say is there in corporates is not so attractive.”
Get alerts on Capital markets when a new story is published